Is The German Eagle a Grey Swan? (Part Two of Two)

With the EMU history lesson behind us we are now brought up to date. Once again, notwithstanding the introduction of a single currency “straightjacket”, Germany has gained in competitiveness. A strong euro has not been an impediment to an impressive German export performance. Yet the European Central Bank and the EU, which helps itself annually to a substantial portion of German taxes, are throwing all manner of support and subsidies at those countries that have chronically underperformed the hard-working Germans and are unable, without assistance, to service their massive and growing debts.

Consider now how Germans feel about this. For decades they have provided vast subsidies and support to other European countries, both via the EU and bilaterally. They spent a huge amount of their savings to help rebuild East Germany following reunification. They thought they were doing Europe a great favour through their willingness to enter into EMU, thereby sharing the fruits of their successful hard-currency policy with their neighbours. Yet how have several of these neighbours returned the favour? By encouraging and subsidising real estate speculation; by standing by while public and private sector unions demanded ever higher wages, eroding competitiveness; by using accounting tricks to hide the true size of their public sector deficits; and then, when it all blew up in their faces, they had the audacity to BLAME THE GERMANS for being wary of more hazard and thus slow to acquiesce to ECB emergency lending facilities and a massive, open-ended EU bailout commitment.

Many Germans are, in a word, furious. However, what should be of greater concern to financial markets is that Germans are now openly debating, in academic and policy circles and well as in the press, just what is in Germany’s best interest. Few believe that the current bailout arrangements are. And in this debate there is little if any sympathy for the club of euro-area countries that have in their view betrayed German good-will and perhaps permanently compromised the hard-earned, hard-currency legacy of the Bundesbank.

Several prominent German economists are now openly advocating that Germany reconsider participation in EU-bailout arrangements which do not require a substantial debt restructuring. Perhaps the most outspoken of these is Dr Hans-Werner Sinn, President of the prominent IFO Institute and member of the German Council of Economic Advisers, colloquially known as the “Five Wise Men”. In a recent paper, Rescuing Europe, he argues that not only have various euro-area countries taken advantage of low borrowing costs to artificially amplify growth by failing to deliver meaningful cuts in fiscal spending; but also that the capital that flowed into housing and unsustainable government spending in the “windfall” economies was German capital that should in fact have stayed in Germany, where investments would have been less speculative and ultimately more sustainable. In other words, German capital has been misallocated and is now at risk of being outright squandered by German participation in ill-conceived bailouts which do nothing to remedy the underlying malaise of the bail-out recipients. Rather, such bailouts create a massive moral hazard problem which virtually ensures that German capital will continue to flow to inefficient, dysfunctional governments.

Needless to say, this paper has caused quite a stir in European financial and political circles. Martin Wolf of the Financial Times, arguably the most influential European financial columnist, has proclaimed Mr Sinn’s views as being both dangerous and wrong, arguing that Germany is a huge beneficiary of EMU and of European integration in general. While Mr Wolf’s rhetoric is impressive, his economics are somewhat less so. Ultimately his argument can be reduced to circular logic: Germany’s neighbours, using German capital, buy German exports, thereby helping Germany. Everybody wins, right? Wrong. That capital has multiple potential uses. That portion that goes to wasteful, unsustainable government policies could, and should, be deployed elsewhere, such as in Germany itself.

We side with Dr Sinn on this one. There is no free lunch in economics. Capital that is misallocated is capital that is forever wasted, never to return. Germans–indeed, all Europeans–would have been better off if, following the start of EMU, capital had flowed to efficient firms, regardless of location, rather than to inefficient governments and property speculation. The former would have used such capital to invest, to innovate, to improve their competitiveness, rather than have used it to keep bloated, inefficient welfare programmes afloat while hiding their true cost behind a dazzling array of derivative transactions designed by the most sophisticated investment banks in the world. Money well spent, to be sure, from the perspective of those who earned enormous bonuses by structuring and executing such transactions. But from an economic point of view, such spending was capital flowing down the proverbial toilet.

As Dr Sinn raises his voice, Germans listen, and the political momentum to do something about the current, open-ended bailout arrangement, grows. A handful of current and former German politicians, including former SDP Bundestag member Prof Wilhelm Noelling, are now pressing the German Constitutional Court to rule one way or the other as to whether open-ended bailouts are permissible under the Maastricht Treaty. Of course they are not. The Court probably already knows this, hence they are reluctant to hear the case. But if the issue is not to be decided by the Court, it will be decided by politics. Up to now, those in favour of the bailout have had the votes on their side. But not by a wide margin. A small shift of just a few votes would swing things the other way.

The German economy is now beginning to weaken. It is early days yet, but the signs are there. Exports are slowing as the global economy runs out of all the stimulus thrown at it in 2008 and 2009. Extrapolate current trends out a year or so and what you have is a German economy that has slowed by enough to push up the unemployment rate slightly. Amidst a continuing debate as to whether Germans should be continuing to provide open-ended bailout funds to others, rising unemployment could well shift the political balance slightly. The risk of Germany reneging on current, tenuous, arguably unconstitutional (ie Treaty-violating) bailout arrangements is going to be higher a year from now that it is today.

Now, who wants to be holding that Greek debt, or shares of European banks exposed to Greece, if that shift occurs? That’s right. No one will touch it. It will be game over. The question then becomes, how large a haircut (loss of capital) will bondholders face in a restructuring? And how will this impact European bank balance sheets and earnings? Well, it won’t be pretty. Now repeat with Ireland. With Portugal. With Spain. With even Italy perhaps.

If Germany does choose to remove its support for open-ended bailouts in favour of qualified support for meaningful sovereign debt restructuring, it could set off another round of disorderly de-leveraging in a fragile global financial system which has not yet meaningfully restored capital lost in the 2008 crisis.

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]

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About John Butler:

John Butler has 17 years experience in the global financial industry, including European and US investment banks in London, New York and Germany. Recently, he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, responsible for development and marketing of proprietary, index-based quantitative strategies in global interest rate markets. Prior to DB, John was Managing Director and Head of European Interest Rate Strategy at Lehman Brothers in London, where his team was voted #1 by Institutional Investor. He has contributed to financial publications including the Financial Times, Wall Street Journal, Boersenzeitung and Handelsblatt.